Don’t be tempted to buy banks – here are two better options

Yesterday was a rotten day for the banks. Shares in Standard Chartered fell 4% after the Asia-focused bank issued a profit warning.

But the real headline-grabber was Barclays. Shares in the bank fell by 6% after the New York Attorney General, Eric Schneiderman, accused the bank of dodgy dealing in its ‘dark pool’ trading facility.

As I don’t own any bank shares, I confess I was feeling a little smug last night. And the latest dive doesn’t tempt me to buy back in – I’m going to continue to steer clear of the sector for a long time to come.

I think there are better places to invest your money out there, and I’m going to tell you what they are – and while I’m at it, I’ll explain what these ‘dark pools’ actually are.

What are ‘dark pools’ and what has Barclays been getting up to?

Dark pools are a good idea that has gone wrong.

They were created because large investors often struggled to invest in a company without moving the share price.

Let’s say you’re a fund manager who runs a £1bn fund. You’re convinced that ABC plc, a £500m company, is one of the biggest bargains on the stock market. So you want to invest a sizeable chunk of cash. That probably means at least 3% of your portfolio, or £30m.

Remember that ABC has a £500m market cap. So if you invest £30m over a short period, you’ll inevitably push up the share price. Part of that rise will be due to increased demand, which is fair enough.

But that’s only part of the story. The other factor will be an increasing awareness that you’re building a stake. When that news leaks out, other investors may follow your lead. And some of those followers will probably invest on a very short-term basis – possibly holding for just a matter of minutes.

These short-term investors will hope to buy shares just ahead of some of your purchases, and then sell the shares to you at a higher price shortly afterwards. These short-term purchases may be driven by computer algorithms which can spot increased trade in milliseconds. In fact, these algorithms are so sophisticated that some ‘high frequency traders’ may be able to spot what you’re doing before you’ve even executed your first purchase. (See more on high-frequency trading and how it works here.)

So the idea of a dark pool is that it enables large investors to buy and sell shares ‘off exchange’ so that other players won’t know what’s going on. Then the large investor only need reveal what he’s done, and at what price, when the whole process is done and dusted.

So what has Barclays been doing?Schneiderman says that Barclays allowed too many different players into its dark pool. As a result, some investors were able to use algorithms on Barclays’ dark pool to figure out what was going on, and make money from that knowledge.

In other words, the Barclays ‘dark pool’ wasn’t doing what it’s supposed to do. Rather than enabling large investors to buy shares on the quiet, it was corralling them altogether, making them an even easier target for the high-frequency traders these large players were trying to avoid in the first place.

If Schneiderman’s legal action is successful, Barclays could be hit by fines and compensation payouts, so it’s not surprising that the share price has fallen. And it’s not just the possible financial loss that bothers me.

I’m also concerned that this latest scandal shows that Barclays chief executive, Anthony Jenkins, still hasn’t won his internal battle to change the culture at the bank. There are still Barclays staff who are prepared to take silly risks doing things that put the bank’s reputation (what’s left of it) and finances on the line.

On top of all this, on Monday, the Independent revealed that the banks more generally could be hit by greatly increased compensation claims for the mis-selling of interest rate swaps. The extra claims could be worth as much as £22bn, it said. Worrying stuff.

Here’s what to buy instead of banks

All this bad news just confirms my view that you’re still better off steering well clear of banks.

You see, banks are always hard to understand, and there’s a persistent concern that they will do whatever they can to make their balance sheets look as stable as possible.

The truth is that many banks still haven’t finished the process of writing down bad loans that emerged during the financial crisis. Until all these loans are written down, there’s always a danger of a big hit to profits when more writedowns finally happen.

If you are subscriber to MoneyWeek and want to find out more about this issue (as well as learning which banks are closest to being out of the woods), read What’s wrong with Britain’s banks by James Ferguson of the MacroStrategy Partnership. (If you’re not already a subscriber, sign up for a free four-week trial to MoneyWeek magazine, you get full access to our web archive where you can read the article.)

So what can you buy instead? I admit that very few shares look cheap right now, but I’d far rather be invested in retail or consumer companies. Valuations are high in many cases here, but at least I can understand these businesses, and the best companies own some strong brands which offer a strong ‘investment moat’. (In other words, it’s hard for a rival to come along and launch a successful competitor – we’ve more on this in this week’s issue of MoneyWeek too.)

One consumer company I like is Diageo (LSE: DGE). It’s got a great portfolio of drink brands, and there’s plenty of room for growth in emerging markets. I also like pharmaceutical stocks. Admittedly these aren’t always easy to understand, but several look attractive on valuation grounds, especially GlaxoSmithKline (LSE: GSK). I own shares in both of these companies.

I don’t disagree that banks are murky and hard to analyse, they should probably be avoided, not for the faint of heart… however, when sentiment has gotten this downbeat over the past few years, it has created opportunities. Valuations-wise (3.5x pre-provisioning profit, 0.65x p/bv, even a 4% div yield until proven otherwise!), barclays is hitting levels that in the past few years have marked great opportunities in US and UK banks (end-2011) and European banks (mid-2012). Insofar as banks are a “market tell”, i.e. their poor performance could be foretelling a broader sell-off, I would personally be more worried about buying the other stuff now. At least banks are pricing in a lot of bad news already.

mdj

‘In other words, the Barclays ‘dark pool’ wasn’t doing what it’s supposed to do. Rather than enabling large investors to buy shares on the quiet…’

Ed, you write interesting and informative stuff for minnows like me to understand the money world better for which, thanks.
So please help me by explaining why it should be a bank’s – or anybody’s – business to help the big guys have even better odds to play the system against small fry like me?
Isn’t this a subversion of the whole point of having a system of openly-traded shares?
That someone is building a position is part of the information that the market needs to know, however much that individual might wish his moves could be carried out secretly for maximum benefit.
Isn’t Schneiderman attacking the wrong abuse? Aren’t you defending one?

We already know that the FT is now distorted by its listing of shares held overseas in countries of (to put it coyly) limited transparency, of which often only a small percentage are openly tradeable. This makes tracking the market an act of faith, rather than calculation.
Stories like this make the small investor think that share ownership is simply a rigged game to be avoided at all costs.
Maybe it was ever thus in one form or another; but can this practice be defended?

Ed Bowsher

Hi mdj,

I’m sorry I haven’t replied to your post earlier. You make a fair point – maybe we shouldn’t have ‘dark pools’. But don’t let that put you off investing in the stock market. It’s become increasingly clear in the last couple of years that various market prices have sometimes been rigged in the very short-term. But it would be much harder to do this over the longer term. As a private investor, you should be thinking in terms of years, so small price movements that are triggered by silly market games aren’t really that important.

And thanks for the kind words about my articles.

Going to Ij1, there’s no doubt that some investors have made good money from investing in banks since 2009. But we fear there could be more bad news to come – for at least some banks – so they’re best avoided now.